Monday, January 4, 2010

Using leverage, or borrowing money to invest, may be out of fashion after the financial crisis, but it is a crucial part of a strategy to protect financial portfolios from inflation, says the head of investment at a large private bank.

In a recent interview with BT, Frederic Lamotte, chief investment officer of Credit Agricole Suisse, the Swiss private banking unit of France's Credit Agricole group, said some leverage is necessary to hedge against the risk of heavily indebted governments inflating away their debts.

'I'm very adamant about this: In a portfolio, even a balanced portfolio, a little debt is absolutely necessary as a tool to fight this form of inflation, which is not yet completely identified,' he said.

'Having a little debt, say 30-40 per cent, is not to endanger the structure of the portfolio, but to put you on the same side as the governments that have highly leveraged balance sheets. If they find the solution for their problem, it will also benefit you.

'Today, everybody talks about de-leveraging. The problem, if you get de-leveraged completely, is that you are a net saver, so you are on the other side of the table as compared to the governments and their taxing power.

'Our worry is about debt at the government level. Historically, there have been three ways to get rid of that debt - through higher taxes, inflation or declaring force majeure (defaulting because of war or other extraordinary events).

Higher taxes 'definitely will come, in the US and Europe', Mr Lamotte said. Inflation, he reckons, is also likely to occur, but not in the way it usually develops - through a self-reinforcing spiral of rising prices and wages.

'We have great difficulty seeing how that would start, because prices can increase but salaries will not. Unemployment is very high in the developed countries, so the price of work is not going to increase.'

'So inflation will take maybe another dimension - exactly what, it's not easy to know yet. But we think that the value of paper money is really at stake here, because there has been a lot of printing.'

His strategy to preserve clients' assets from being eroded by inflation is to invest in so-called 'real assets' - gold, industrial metals, real estate and private equity - and using borrowed money, or leverage, to fund some of those investments.

'At the start of 2009, we had 10 per cent gold in our balanced portfolio - a standard portfolio for a standard client,' he said. In mid-November, 'we took profit on 2.5 per cent of the gold and replaced it with 2.5 per cent of industrial metals - mainly copper, aluminium and zinc - and we're going to raise that allocation to around 7 per cent'.

'So overall, precious and industrial metals will make up about 15 per cent of our portfolio' in early 2010.'

Demand for gold is likely to be driven by Asian central banks that have very low gold reserves to catch up with their Western counterparts, he believes.

'And industrial metals have a capacity of storage of value which is very important for emerging markets.

'To build highways and buildings, you need metal - copper for the wire, zinc for the roofs. Whether you buy zinc today or 20 years from now, you know you'll be using it anyway, because of the long-term, massive investment in China.'

Just a quarter of Mr Lamotte's recommended standard portfolio will be in listed equities at the start of 2010, after cutting equity exposure in November and replacing half of it with a derivative position to protects the portfolio from any slump in equity prices before the end of 2009, he said.

'The momentum in equities in 2009 was driven by earnings, which is good, but those earnings were driven by cost-cutting. You can cut costs a few times, but after that you start cutting into bone. It's going to be difficult to do the same exercise to generate further earnings in 2010, so we will wait until the end of the first quarter to see if we get increasing revenues. After that, we will probably be more aggressive.'

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